Risk and Return

Investors purchase financial assets such as shares of stock because they desire to increase their wealth, i.e., earn a positive rate of return on their investments. The future, however, is uncertain; investors do not know what rate of return their investments will realize.

In finance, we assume that individuals base their decisions on what they expect to happen and their assessment of how likely it is that what actually occurs will be close to what they expected to happen. When evaluating potential investments in financial assets, these two dimensions of the decision making process are called expected return and risk.

The concepts presented in this section include the development of measures of expected return and risk on an indivdual financial asset and on a portfolio of financial assets, the principle of diversification, and the Captial Asset Pricing Model (CAPM).